Why calculating profitability is crucial for management

What does every company need to be successful? Profit, of course. But how high should the profit be in order to speak of success? And how can you calculate profitability without getting lost in chaotic Excel sheets or a huge stack of receipts? Why is the profit margin perhaps even more important? And what is profitability? Let us explain.

The difference between profit, profit margin, return on investment & profitability

Profit is the positive difference between all revenues and all costs of a company during a certain period. It is the amount that remains after deducting all expenses, including operating costs, taxes, interest, and other costs, from the revenues. It is an absolute value expressed in hard euros. If this result is negative, we obviously speak of a loss.

Profit margin is the percentage relationship between profit and the revenue of a company. You measure the profitability of the individual products or services. This way, you can calculate the gross profit margin, net profit margin, or operating profit margin for each product or service. These profit margins provide insight into the profitability of a company based on income and expenses. They give you an idea of which products or services yield relatively high or low returns.

Return on investment is the return a company makes on invested capital. You calculate this for both equity and debt capital.

We express overall profitability as a percentage. We measure to what extent the entire company is able to generate profit from its activities. It provides insight into how efficiently a company can generate profit compared to revenue, costs, investments, or equity. We assess profitability by looking at the gross profit margin, net profit margin, return on equity, return on investment, etc.

In short:

• Profit is the actual financial outcome.
• Profit margin calculates the profitability per product or service.
• Return on investment calculates the return a company makes on its equity and debt capital.
• Profitability calculates how much profit a company can generate with its activities.

Why profitability is so important

The results of these calculations can have far-reaching consequences. The outcomes assist top management and the board of directors in making various decisions.

Competitive position: You can compare the profit margins and profitability against the average percentages in the industry. You can imagine that the profit margins for Ferrari and Jamin differ significantly. The profitability of both companies can be excellent. If the margins are found to be low compared to the average, the workflow needs to be examined.

Financial position: The figures provide insights into profitability in relation to equity and debt capital. These results are important for potentially attracting new investors or the ability to secure business loans from banks.

Product portfolio: If a product or service is popular among customers but has a very low profit margin, it raises questions whether the company can continue in the same way.
The options seem simple:

1. Increase the selling price.
2. Reduce costs.
3. Change the workflow.
4. Accept the low profit margin.
5. Stop.

There are multiple options to consider in order to increase the profit margin and profitability of a product or service. You can only do this if you have maintained detailed records at the product or project level.

Tips for calculating profitability

To ensure that the board of directors can make the right decisions, it is crucial to have a clear overview of income and expenses. Like many other business processes, the execution of administrative tasks often becomes a bottleneck. Can costs be eliminated? When does the quality become compromised? When are too many people working too many hours on a product or service that yields little profit? Here are some useful tips:

• Smart software solutions: There are many tools available that allow you to register worked hours, expenses, project management, and invoicing based on hourly rates. Typically, you can integrate these programs or even use an all-in-one software solution to simplify or fully automate profit calculations.
• Regular monitoring: Regularly check the finances to ensure that you keep an eye on profitability. Ideally, all data from your tracking software should be displayed in clear dashboards. This way, you can see at a glance how all the numbers relevant to profit margins are performing in your company.
• Additional key figures: Profitability is important, but it’s not the only financial goal for your company. Consider other ratios such as cash flow, total revenue, revenue per FTE (Full-Time Equivalent), and return on investment to measure business success.

Conclusion & Recommendation

If you are looking for the right software solution to simplify the calculation of the overall profitability of your company, we have the following recommendation for you:

TimeChimp is a multifunctional tool for expense and time registration, allowing you to easily track project and labour costs based on working hours and hourly rates, as well as all recorded expenses. This smart tool not only has numerous features but can also be easily integrated with external applications such as your accounting software through handy integrations and an open API interface. This way, you always have up-to-date income and expense information at hand to regularly calculate the profitability of products, services, or your entire company.

Easy does it.